Accounting For Depreciation:

Learning Objectives: 1. Define and explain the term "depreciation". 2. Why does depreciation calculated and charged? 3. What are the different methods for providing depreciation? Definition and Explanation of Depreciation: The value of assets gradually reduces on account of use. Such reduction in value is known as depreciation. Different authors have given different definitions of depreciation. Click here to read full article. Causes of Depreciation: The main causes of depreciation may be divided into two categories, namely:

1. Internal Cause and 2. External Causes Click here to read full article.
Need for Depreciation: Depreciation is a loss. So Unless it is considered like all other expenses and losses, true profit or loss cannot be ascertained. In other words, depreciation must be considered in order to find out true profit or loss of a business. Click here to read full article. Depreciation, Depletion and Amortization: The term depreciation is used with reference to tangible fixed assets because the permanent continuing and gradual fall in book value is possible only in the case of fixed asset. Click here to read full article. Difference Between Depreciation and Fluctuation: Depreciation of asset and fluctuation in its market value are not the same. For example, a businessman purchase a machine the life of which is estimated at 10 years and charges depreciation accordingly each year. If for certain reasons the market value of the machine decreases by say 20%, the businessman need not consider this decrease at all. Click here to read full article. Basic Factors of Determination of Depreciation: Read about the basic factors for the calculation of depreciation. Click here. Depreciation Methods / Methods for Providing Depreciation: Fixed assets differ from each other in their nature so widely that the same depreciation methods cannot be applied to each. Click here to read full article. Fixed Installment Method / Straight Line Method / Original Cost Method:

Fixed installment method is also know as straight line method or original cost method. Under this method the expected life of the asset or the period during which a particular asset will render service is the calculated. Click here to read full article. Diminishing balance/written Down Value/Reducing Installment Method of Depreciation: Diminishing balance method is also known as written down value method or reducing installment method. Under this method the asset is depreciated at fixed percentage calculated on the debit balance of the asset which is diminished year after year on account of depreciation. Click here to read full article. Annuity Method of Depreciation: According to this method, the purchase of the asset concerned is considered an investment of capital, earning interest at certain rate. The cost of the asset and also interest thereon are written down annually by equal installments until the book value of the asset is reduced to nil or its bread up value at the end of its effective life. Click here to read full article. Depreciation Fund Method or Sinking Fund Method: Depreciation fund method is also know as sinking fund method or amortization fund method. Under this method, a fund know as depreciation fund or sinking fund is created. Click here to read full article. Insurance Policy Method of Depreciation: Insurance policy method is a slight modification of the depreciation fund method or sinking fund method. Under this method the amount represented by the depreciation fund, instead of being used to buy securities, is paid to an insurance company as premium. The insurance company issues a policy promising to pay a lump sum at the end of the working life of the asset for its replacement. Click here to read full article. Revaluation Method of Depreciation: As the name implies under revaluation method, the assets are valued at the end of each period so that the difference between the old value and the new value, which represents the actual depreciation can be charged against the profit and loss account. Click here to read full article. Sum of the Years' Digits Method of Depreciation: Sum of the Years' Digits Method an accelerated method of depreciation which is also based on the assumption that the loss in the value of the fixed asset will be greater during the earlier years and will go on decreasing gradually with the decrease in the life of such asset. Click here to read full article. Double Declining Balance Method of Depreciation: Double declining balance method is another type of accelerated depreciation method followed generally in USA. The depreciation expense is computed by multiplying the asset cost less accumulated depreciation by twice the straight line rate expressed in percentage. Click here to read full article.

Depletion Method of Depreciation: Depletion method of depreciation is especially suited to mines, quarries, sand pits, etc. According to it the cost of the asset is divided by the total workable deposits. In this way, rate of depreciation per unit of output is ascertained. Depreciation in any particular year is charged on the basis of the output during that year. Click here to read full article. Basis of Use System of Depreciation: One of the chief factors causing depreciation is use. For example in case of plant and machinery, it is the total number of hours for which the machines work is the main factor and not their life. Click here to read full article. Depreciation Of Various Assets: We discuss the problem of depreciating some given assets. Click here to read full article Depreciation Accounting - General Questions and Answers: Find answers of some of the general questions about depreciation. Click here.

Definition, Explanation and Characteristics of "Depreciation" or "Accounting Depreciation":

Learning Objectives: 1. Define and explain the terms "depreciation" or "accounting depreciation". The value of assets gradually reduces on account of use. Such reduction in value is known as depreciation. Different authors have given different definitions of depreciation, such as: "Depreciation may be defined as the permanent continuous diminution in the quality, quantity or value on an asset." (By Pickles) "Depreciation is the gradual permanent decrease in the value of an asset from any cause." (By Carter) "Depreciation may be defined as a measure of the exhaustion of the effective life of an asset from any cause during a given period." (By Spicer & Pegler) Depreciation is the diminution in intrinsic value of an asset due to use and/or the lapse of time." (By Institute of Cost and Management Accountants, England) "Depreciation is the reduction in the value of a fixed asset occasioned by physical wear and tear, obsolescence or the passage of time." (Northcott & Forsyth) "Depreciation is the diminution in the value of assets owing to wear and tear, effluscion of time, obsolescence or similar causes." (Cropper) From the above definitions, it follows that an asset gradually declines on account of use and passage of time and this causes permanent reduction in the value and utility of asset. Such reduction in the value or utility of asset is called depreciation. In other words, expired cost or utility of asset is depreciation.

Characteristics of Depreciation:
Depreciation has the following characteristics:

1. Depreciation is charged in case of fixed assets only. e.g., building, plant and machinery, furniture etc.
2. 3. 4. 5. There is no question of depreciation in case of current assets - such as stock, debtors, bills receivable etc. Depreciation causes perpetual, gradual and continual fall in the value of assets. Depreciation occurs till the last day of the estimated working life of the asset. Depreciation occurs on account of use of asset. In certain cases, however, depreciation may occur even if the assets are not used, e.g., leasehold, property, patent, copyright etc. Depreciation is a charge against revenue of an accounting period. Depreciation does not depend on fluctuations in market value of assets (see difference between depreciation and fluctuation page).

6.

7. The amount of depreciation of an accounting year cannot be determined precisely - it has to be estimated. In certain cases, however, it may be ascertained exactly, e.g., leasehold property, patent right, copyright etc. 8. Total depreciation of an asset cannot exceed its depreciable value (cost less scrap value).

Causes of Depreciation:
Learning Objectives: 1. What are the causes of definition? The main causes of depreciation may be divided into two categories, namely:

1. Internal Cause and 2. External Causes

Internal Causes:
Depreciation which occurs for certain inherent normal causes, is known as internal depreciation. The main causes of internal depreciation are:

Wear and Tear:

Some assets physically deteriorate due to wear and tear in use. More and more use of an asset, the greater would be the wear and tear. Physical deterioration of an asset is caused from movement, strain, friction, erasion etc. An obvious example of this is motor car which rapidly wears out. Other assets like this are building, plant, machinery, furniture, etc. The wear and tear is general but primary cause of depreciation.

Depletion:
Some assets declines in value proportionate to the quantum of production, e.g. mine, quarry etc. With the raising of coal from coal mine the total deposit reduces gradually and after sometime it will be fully exhausted. Then its value will be reduced to nil.

External Causes:
Depreciation caused by some external reasons is called external depreciation. The main external causes are as follows:

Obsolescence:
Some assets, although in proper working order, may become obsolete. For example, old machine becomes obsolete with the invention of more economical and sophisticated machine whose productive capacity is generally larger and cost of production is therefore less. In order to survive in the competitive market the manufacturers must must install new machines replacing the old ones. Again, it may happen that the articles produced by old machine are no longer saleable in the market on account of change of habit and taste of the

people. In such a case the old machine, although in good working condition, must be discarded and the new one purchased.

Efflux of Time:
Some assets diminish in value on account of sheer passage of time, even though they are not used e.g., leasehold property, patent right, copyright etc. Suppose we take a lease of a house for 10 years for $10,000. Its annual depreciation will be $1,000 (10,000/10), irrespective of the the whether the house has been used or not. Because with the end of lease after 10 years, the house will go out of possession.

Accident:
Assets may be destroyed by abnormal reasons such as fire, earthquake, flood etc. In such a case the destroyed asset must be written off as loss and a new one purchased.

Need for Depreciation:

Learning Objectives: 1. Why does the need for calculating and charging depreciation arise. The Need for depreciation arises for the following reasons:

Ascertainment of True Profit or Loss:

Depreciation is a loss. So Unless it is considered like all other expenses and losses, true profit or loss cannot be ascertained. In other words, depreciation must be considered in order to into out true profit or loss of a business.

Ascertainment of True Cost of Production:

Goods are produced with the help of plant and machinery which incurs depreciation in the process of production. This depreciation must be considered as a part of the cost of production of goods. Otherwise, the cost f production would be shown less than the true cost. Sales price is fixed normally on the basis of cost of production. So, if the cost of production is shown less by ignoring depreciation, the sale price will also be fixed at low level resulting in a loss to the business.

True Valuation of Assets:

Value of assets gradually decreases on account of depreciation, if depreciation is not taken into account, the value of asset will be shown in the books at a figure higher than its true value and hence the true financial position of the business will not be disclosed through balance sheet.

Replacement of Assets:
After sometime an asset will be completely exhausted on account of use. A new asset must then be purchased requiring a large sum of money. If the whole amount of profit is withdrawal from business each year without considering the loss on account of depreciation, necessary sum may not be available for buying the new asset. In such a case the required money is to be collected by introducing fresh capital or by obtaining loan or by selling some other assets. This is contrary to sound commerce policy.

Keeping Capital Intact:

Capital invested in buying an asset, gradually diminishes on account of depreciation. If loss on account of depreciation is not considered in determining profit or loss at the year end, profit will be shown more. If the excess profit is withdrawal, the working capital will gradually reduce, the business will become weak and its profit earning capacity will also fall.

Depreciation, Depletion and Amortization:

Learning Objectives: 1. What is the difference among depreciation, depletion, and amortization.

Depreciation:
The term depreciation is used with reference to tangible fixed assets because the permanent continuing and gradual fall in book value is possible only in the case of fixed asset.

Depletion:
The term depletion is used for the depreciation of wasting assets such as mines, oil wells, timber trees etc.

Amortization
The term amortization is used in respect of intangible assets like patents, copyrights, leasehold and goodwill which are recorded at cost. Some intangible assets have limited useful life and are, therefore, written off. The process of their writing off is called amortization.

Difference Between Depreciation and Fluctuation:

Learning Objectives: 1. What is the difference between depreciation and fluctuation?.

Depreciation of asset and fluctuation in its market value are not the same. For example, a businessman purchase a machine the life of which is estimated at 10 years and charges depreciation accordingly each year. If for certain reasons the market value of the machine decreases by say 20%, the businessman need not consider this decrease at all. Because the productive capacity or the utility of the machine to the businessman has not been reduced on account of fall in its market value. So he will not have to suffer any loss, unless he sells the machine. But the machine is not intended for sale - it will be used permanently in the business. So the business will ignore the fall in market price. But depreciation cannot be ignored - it must be considered. Thus we see that there is no relationship between depreciation and fluctuation. The points of difference between depreciation and fluctuation are stated below in a tabular form:

Depreciation 1. It reduces productive capacity or

utility of asset.

Fluctuation 1. It does not reduce productive capacity or utility of asset. 2. It may not occur 3. The value of asset may arise or fall on account of fluctuation. 4. Generally it is not taken into account. However, in case of
current assets permanent fall in price is considered.

2. It must occur 3. It reduces value of asset

gradually.

4. Loss by way of depreciation must

be considered.

5. It is a regular loss - it must be

charged throughout the working life of asset.

5. It is generally irregular.

6. It always indicates loss

6. It may indicate either profit or loss. Increase in market value

means profit, while decrease means loss.

Basic Factors of Determination of Depreciation:

Learning Objectives: 1. What are the basic factors of depreciation determination? For calculation depreciation the basic factors are:

1. The original cost of the asset. 2. The estimated working life of the asset or the number of years the asset is expected to last. 3. The estimated residual or scrap value at the end of its life. It is the value which the asset will fetch
when discarded as useless.

4. The amount to be spent periodically for repairs and renewals. If the repairs necessary to keep the

asset in a proper state of efficiency are regularly carried out, the life of the asset is prolonged and the amount of annual depreciation is proportionately lowered.

5. The possibility of the asset becoming obsolete. If there are great chances of improvements being made
in a particular asset on account of inventions, higher depreciation should be written off such an asset. Usually engineers and experts give their opinion about these and they are accepted by businessmen. After getting information on all these points, it is easy to access the rate of depreciation.

Depreciation Methods:
Learning Objectives: 1. What are the various methods for depreciation? Fixed assets differ from each other in their nature so widely that the same depreciation methods cannot be applied to each. The following methods have therefore been evolved for depreciating various assets: 1. Fixed installment or Straight line or Original cost method. 2. Diminishing Balance Method or Written down value method or Reducing Installment method. 3. Annuity Method. 4. Depreciation fund method or Sinking fund amortization fund method. 5. Insurance policy method. 6. Revaluation method. 7. Sum of the year's digits method (SYD). 8. Double declining balance method. 9. Depletion method. 10. The basis of use system.

Fixed Installment Method or Straight Line Method or Original Cost Method of Depreciation:
Learning Objectives: 1. Define, explain and give example of fixed installment or straight line or original cost method. 2. What are the advantages and disadvantages of of using this method? Fixed installment method is also know as straight line method or original cost method. Under this method the expected life of the asset or the period during which a particular asset will render service is the calculated. The cost of the asset less scrap value, if any, at the end f its expected life is divided by the number of years of its expected life and each year a fixed amount is charged in accounts as depreciation. The amount chargeable in respect of depreciation under this method remains constant from year to year. This method is also know as straight line method because if a graph of the amounts of annual depreciation is drawn, it would be a straight line.

Formula:
The following formula or equation is used to calculate depreciation under this method: Annual Depreciation = [(Cost of Assets - Scrap Value)/Estimated Life of Machinery]

Journal Entries:
The journal entries that will have to be made under this method are very simple. The journal entries will be as under:

1. Depreciation account

To Asset account
(Being the depreciation of the asset)

2. Profit and loss account

To Depreciation account
(Being the amount of depreciation charged to Profit and Loss account)

These entries will be passed at the end of each year so long as the asset lasts. In the last year, the scrap will be sold and with the amount that realised by the sale the following entry will be passed:

3. Cash account
To Asset account
(Being the sale price of scrap realised.)

Advantages:
1. Fixed installment method of depreciation is simple and easy to work out 2. The book value of the asset can be reduced to zero.

Disadvantages:
1. This method, in spit of its being simplest is not very popular because of the fact that whereas each
year's depreciation charge is equal, the charge for repairs and renewals goes on increasing as the asset becomes older. The result is that the profit and loss account has to bear a light burden in the initial years of the asset but later on this burden becomes heavier. Interest on money is locked up in the asset is not taken into account as is done in some other methods. No provision for the replacement of the asset is made. Difficulty is faced in calculation of depreciation on additions made during the year.

2. 3. 4.

Scope of Application:
On account of the above mentioned advantages and disadvantages of fixed installment method, it is generally applied in case of those assets which have small value or which do not require many repairs and renewals for example copyright, patents, short leases etc.

Example:
On 1st January 1991 X purchased a machinery for $21,000. The estimated life of the machine is 10 years. After it its break up value will be $1,000 only. Calculate the amount of annual depreciation according to fixed installment method (straight line method or original cost method) and prepare the machinery account for the first three years. Machinery Account Debit Side $ Credit Side $

1991 Jan. 1

To Bank account

21,000

1991 Dec. 31 1991 Dec. 31

By Depreciation account By Balance c/d

2,000 19,000 21,000

21,000
1992 Jan. 1

To Balance b/d

19,000

1991 Dec. 31 1991 Dec. 31

By Depreciation account

2,000 17,000 15,000

15,000
1993 Jan. 1

To Balance b/d

17,000

1991 Dec. 31 1991 Dec. 31

By Depreciation account By Balance c/d

2,000 15,000 17,000

17,000

Diminishing Balance Method of Depreciation:

Learning Objectives: 1. Define, explain and give example of the diminishing balance method/written down value method/reducing installment method? 2. What are advantages and disadvantages of diminishing balance method?

Definition and Explanation:

Diminishing balance method is also known as written down value method or reducing installment method. Under this method the asset is depreciated at fixed percentage calculated on the debit balance of the asset which is diminished year after year on account of depreciation.

Journal Entries:
The entries in this case will be identical to those discussed in the case of the fixed installment method. Only the amount will be differently calculated.

Advantages of Diminishing Balance Method:

1. The strongest point in favor of this method is that under it the total burden imposed on profit an loss
account due to depreciation and repairs remains more or less equal year after year since the amount after depreciation goes on diminishing with the passage of time whereas the amount of repairs goes on increasing an asset grow older.

2. Separate calculations are unnecessary for additions and extensions, though in the first year some
complications usually arise on account of the fact that additions are generally made in the middle of the year.

Disadvantages of Diminishing Balance method:

1. This method ignores the question of interest on capital invested in the asset and the replacement of 2. 3.
the asset. This method cannot reduce the book value of an asset to zero if it is desired. Very high rate of depreciation would have to be adopted other wise it will take a very long time to write an asset down to its residual value

Scope of Application:
Diminishing balance method of depreciation is most suited to plant and machinery where additions and extensions take place so often and where the question of repairs is also very important. Written down value method or reducing installment method does not suit the case of lease, whose value has to be reduced to zero.

Example:
On 1st January, 1994, a merchant purchased plant and machinery costing $25,000. It has been decided to depreciate it at the rate if 20 percent p.a. on the diminishing balance method (written down value method). Show the plant and machinery account in the first three years. Plant and Machinery Account Debit Side Date
1994 Jan. 1

Credit Side $ Date

1994 Dec. 31 "

$ By Depreciation By Balance c/d 5,000* 20,000 25,000

To Cash

25,000

25,000
1995 Jan. 1

To Balance b/d

20,000

1995 Dec. 31 "

By Depreciation By Balance c/d

4,000**
16,000 20,000

20,000
1996 Jan. 1

To Balance b/d

16,000

1996 Dec. 31

By Depreciation

3,200***
12,800 16,000

By Balance c/d
16,000

Formula or equation for the depreciation calculation may be written as follows:

*First year: 25,000 20% = 5000 **Second Year: (25000 - 5000) 20% = 4,000 ***Third Year: [25000 - (5,000 + 4,000)] 20% = 3,200

Annuity Method of Depreciation:

Learning Objectives: 1. What is annuity method of depreciation? Where is it adopted? According to this method, the purchase of the asset concerned is considered an investment of capital, earning interest at certain rate. The cost of the asset and also interest thereon are written down annually by equal installments until the book value of the asset is reduced to nil or its bread up value at the end of its effective life. The annual charge to be made by way of depreciation is found out from annuity tables. The annual charge for depreciation will be credited to asset account and debited to depreciation account, while the interest will be debited to asset account and credited to interest account.

Journal Entries:
Under annuity method, journal entries have to be made in respect of interest and depreciation. As regards interest, it has to be calculated on the debit balance of the asset account at the commencement of the period, at the given rate. The entry that is passed: 1. Asset account To Interest account
(Being interest on capital sunk in asset)

With regard to depreciation the amount found out from the depreciation annuity table, the following entry is passed:

2. Depreciation account To Asset account

(Being the depreciation of asset)

It should be remembered that the interest is charged on the diminishing balance of the asset account, the amount of interest goes on declining year after year. But the amount of depreciation remains the same during the life time of the asset.

Example:
A firm purchased a 5 years' lease for $40,000 on first January. It decides to write off depreciation on the annuity method. Presuming the rate of interest to be 5% per annum. Show the lease account for the first 3 years. Calculations are to be made to the nearest dollar. Annuity Table Amount required to write off $1 by the annuity method.
Years 3 4 5 6 7 8 3% 0.353530 0.269027 0.218355 0.184598 0.160506 0.142456 3.5% 0.359634 0.272251 0.221418 0.187668 0.163544 0.145477 4% 0.360349 0.275490 0.224627 0.190762 0.166610 0.148528 4.5% 0.363773 0.278744 0.227792 0.193878 0.169701 0.151610 5% 0.367209 0.282012 0.230975 0.197017 0.172820 0.154722

Solution:
According to the annuity table given above, the annual charge for depreciation reckoning interest at 5 percent p.a. would be: 230975 40,000 = $9,239 Lease Account
Debit Side Date 1st Year Jan. 1 Dec. 31 To Cash To Interest 40,000 2,000 42,000 2nd Year Jan. 1 Dec. 31 To Balance b/d To Interest 32,761 1,638 34,399 2nd Year Dec. 31 By Depreciation By Balance c/d 9,239 25,160 34,399 $ Date 1st Year Dec. 31 By Depreciation By Balance c/d 9,239 32,761 42,000 Credit Side $

3rd Year Jan. 1 Dec. 31 To Balance b/d To Interest 25,160 1,258 26,418 3rd Year Jan. 1 To Balance b/d 17,170 Dec. 31 By Depreciation By Balance c/d 9,239 17,179 26,418

Advantages:
1. This method takes interest on capital invested in the asset into account. 2. It is regarded as most exact and precise from the point of view of calculations; and is therefore most scientific.

Disadvantages:
1. The system is complicated. 2. The burden on profit and loss account goes on increasing with the passage of time whereas the amount of depreciation charged each year remains constant. The amount of interest credited goes on diminishing as years pass by, the ultimate consequence being that the net burden on profit and loss account grows heavier each year. 3. When the asset requires frequent additions and extensions, the calculation have to be changed frequently, which is very inconvenient.

Scope of Application:
This method is best suited to those assets which require considerable investment and which do not call for frequent additions e.g., long lease.

Depreciation Fund Method or Sinking Fund Method of Depreciation:

Learning Objectives: 1. What is depreciation fund method or sinking fund method of depreciation? 2. What are its advantages and disadvantages?

Definition and Explanation:

Depreciation fund method is also know as sinking fund method or amortization fund method. Under this method, a fund know as depreciation fund or sinking fund is created. Each year the profit and loss account is debited and the fund account credited with a sum, which is so calculated that the annual sum

credited to the fund account and accumulating throughout the life of the asset may be equal to the amount which would be required to replace the old asset. In order that ready funds may be available at the time of replacement of the asset an amount equal to that credited to the fund account is invested outside the business, generally in gilt-edged securities. The asset appears in the balance sheet year after year at its original cost while depreciation fund account appears on the liability side.

Journal Entries:
The following entries are necessary to record the depreciation and replacement of an asset by this method. (a). First year (at the end) (1). Debit profit and loss account and credit depreciation fund account with the amount of the annual depreciation charge. (2). Also debit depreciation fund investment account and credit cash account with an equal amount. (b). In subsequent years. (1). Debit depreciation fund investment account and credit depreciation fund account with the amount of interest earned and reinvested. (2). Debit profit and loss account and credit depreciation fund account with the annual depreciation installment. (3). Debit depreciation fund investment account and credit cash account with an equal amount. (c). On replacement of asset. (1). Debit cash account and credit depreciation fund investment account with the amount realized by the sale of investment. (2). Transfer any profit or loss on sale of investment to profit and loss account. (3). Debit the new asset purchased and credit cash account.

(4). Debit depreciation fund account and credit the account of the old asset which has become useless.
The amount of annual depreciation to be provided for by the depreciation fund method will be ascertained from sinking fund table. Sinking Fund Table Annual sinking fund installment to provide $1.
Years 3 4 5 6 7 8 3% 0.323540 0.239027 0.188350 0.154598 0.130506 0.112446 3.5% 0.321934 0.237251 0.186481 0.152668 0.128544 0.110477 4% 0.320349 0.235490 0.184627 0.150762 0.126610 0.108528 4.5% 0.318773 0.233741 0.182792 0.148878 0.124701 0.106610 5% 0.317208 0.232012 0.180975 0.147017 0.122820 0.104722

Example:
On 1st January, 1990 a four years lease was purchased for $20,000 and it is decided to make provision for the replacement of the lease by means of a depreciation fund, the investment yielding 4 percent per annum interest. Show the necessary ledger account.

Solution:
To get $1 at the end of 4 years at 4 percent an annual investment of $2,35,490 is necessary. Therefore, for $20,000 an annual investment of $4,709.80 i.e., 2,35,490 20,000 will be necessary. Lease Account
1990 Jan.1 To Cash 20,000 1990 Dec. 31 By Depreciation fund 20,000

Depreciation Fund Account

1990 Dec. 31 To Balance c/d 1991 Dec. 31 To Balance c/d 9607.99 4,709.80 1990 Dec. 31 1991 Jan. 1 Dec. 31 " 9607.99 1992 Dec. 31 To Balance c/d 14702.11 1992 Jan. 1 Dec. 31 " 14702.11 1993 Dec. 31 To Lease account 20,000 1993 Jan. 1 Dec. 31 By Balance b/d By Depreciation fund investment By P & L 20,000 14702.11 588.9 4,709.80 20,000 By Balance b/d By Depreciation fund investment By P & L account 9607.99 384.32 4709.80 14702.11 By Balance c/d By Depreciation fund investment By P&L account 4709.80 188.39 4709.80 9607.99 By P & L account 4,709.80

Depreciation Fund Account

1990 Dec. 31 To Cash 4709.80

1990 Dec. 31 By Balance c/d 4709.80

1991 Jan. 1 Dec. 31 Dec. 31 To Balance b/d To Depreciation fund To Cash 4709.80 188.39 4,709.80 9,607.99 1992 Jan. 1 Dec. 31 Dec. 31 To Balance b/d To Depreciation fund To Cash 9,607.99 384.32 4709.80

1991 Dec. 31 By Balance c/d 9,607.99

9,607.99 1992 Dec. 31 By Balance c/d 14,702.11

1993 Jan. 1 Dec. 31 Dec. 31 14,702.11 588.9 4709.80 20,000

1993 Dec. 31 By Cash 20,000.00

20,000

Note: The cash installment at the end of the last year will not be invested because there is no point in buying the investment and selling them on the same date.

Advantages of Depreciation Fund Method Or Sinking Fund Method:

The most important advantages of this method is that it makes available a sum of money for the replacement of the asset, which has become useless. If separate provision was not made, the sum required to purchase the new asset will have to be drawn from the business which might effect the financial position of the concern adversely.

Disadvantages of the Depreciation Fund Method Or Sinking Fund Method:

1. The burden on profit and loss account goes on increasing as years pass by since the amount of depreciation every year remains same but the amount spent on repairs goes on increasing as the asset becomes old. 2. It can also be said that the work of investing money is complicated. 3. Prices of securities may fall at the time when they are to be realized as a result of which loss may have to be suffered.

Scope of Application:
This method is found suitable wherever it is desired not only to charge depreciation but also to replace the asset as happens in the case of plant and machinery and other wasting assets.

Insurance Policy Method of Depreciation:

Learning Objectives: 1. Define and explain the insurance policy method of depreciation.

Definition and Explanation:

Insurance policy method is a slight modification of the depreciation fund method or sinking fund method. Under this method the amount represented by the depreciation fund, instead of being used to buy securities, is paid to an insurance company as premium. The insurance company issues a policy promising to pay a lump sum at the end of the working life of the asset for its replacement. The advantage of insurance policy method is that risk of loss on the sale of investment and the trouble and expense of buying investment are avoided, while disadvantage lies that the interest received on the premiums paid is comparatively very low. When insurance policy method is employed the policy account will take the place of the depreciation fund investment account and no interest will be received at the end of each year, but the total interest on the premiums will be received when the policy matures.

Entries:
Every years two entries will be made:

1.

In the beginning: Depreciation insurance policy account To Cash account

(Being the payment of premium on depreciation policy)

2.

At the end of the year: Profit and loss account To Depreciation fund account
(Being the amount of depreciation charged to profit and loss account)

When the policy will mature i.e., to say the amount of the policy will be received. The entry is: Cash account 3. To Depreciation insurance policy account
(Being the policy amount realized)

The depreciation insurance policy account will show some profit. This will be transferred to depreciation fund account, the entry being. Depreciation insurance policy account 4. To Depreciation fund account
(Being the policy amount realized)

The asset account will have been shown throughout at its original cost. It now be written off by transfer to

depreciation fund account. The entry is: Depreciation fund account 5. To Asset account

Insurance Policy Method Example:

On 1st January, 1990 a business purchases a three year lease of premises for $20,000 and it is decided to make a provision for replacement of the lease by means o an insurance policy purchased for annual premium. Show the ledger accounts dealing with this matter.

Solution:
Leasehold Account
Dr. Side 1990 Jan. 1 To Cash 20,000 1990 Dec. 31 By Depreciation fund 20,000 Cr. Side

Depreciation Fund Account

Dr. Side 1990 Dec. 31 To Balance c/d 6,400 1990 Dec. 31 By Profit and loss a/c 6,400 Cr. Side

1991 Dec. 31 To Balance c/d 12,800 By Balance b/d By Profit and Dec. 31 loss a/c Jan. 1 6,400 6,400

12,800 1992 Dec. 31 To Leasehold Property 20,000 1992 By Balance b/d By Profit and Dec. 31 loss a/c Jan. 1 " 20,000 By Leasehold

12,800

12,800 6,400 800 20,000

Leasehold Policy Account

Dr. Side 1990 Dec. 31 To Cash 6,400 1990 Dec. 31 By Balance c/d 6,400 Cr. Side

1991 Jan. 1 To Balance b/d Dec. 31 To Cash 6,400 6,400 12,800 To Balance b/d To Cash 12,800 6,400 800 20,000

1991 Dec. 31 By Balance c/d 12,800

12,800 By Cash 20,000

20,000

Revaluation Method of Depreciation:

Learning Objectives: 1. Define and explain the revaluation method of depreciation. 2. When and where this method is used? As the name implies under revaluation method, the assets are valued at the end of each period so that the difference between the old value and the new value, which represents the actual depreciation can be charged against the profit and loss account. This method is mostly used in case of assets like bottles, horses, packages, loose tools, casks etc. On rare occasions when on revaluation the value of an asset is found to have increased, it being of temporary nature not taken into account. Revaluation method is open to various objections. Firstly, the method do not specify as to which is the value that the experts are to estimate at the end of each year. It however appears that this is the market value. If so, to assess depreciation with reference to market value is against the basic principles and theory of depreciation. A fixed asset has nothing to do with market value. Secondly, the charge against profit and loss account on account of depreciation will vary year to year through the asset renders the same service throughout of its life time. Thirdly, this method is unscientific, because there are great chance of manipulations.

Sum of the Years' Digits Method of Depreciation:

Learning Objectives: 1. Explain the sum of the years' digits method of depreciation.

Definition and Explanation:

Sum of the Years' Digits Method an accelerated method of depreciation which is also based on the assumption that the loss in the value of the fixed asset will be greater during the earlier years and will go on decreasing gradually with the decrease in the life of such asset. The SYD is found by estimating an asset's useful life in years, then assessing consecutive numbers to each year, and totaling these numbers. For n years: SYD = 1 + 2 + 3 + 4 + ...... + n For example if the useful life of an asset is 5 years, the SYD would be 1 + 2 + 3 + 4 + 5 = 15. Determining the SYD factor by simple addition can be somewhat laborious for long-lived assets. For these assets the formula n (n + 1) / 2 where n = the number of periods in the asset's useful life can be applied to derive the SYD. In our example, we have: 5(5 + 1) = 2 2 30 = 15

The yearly depreciation is then calculated by multiplying the total depreciable amount for the life of the asset by a fraction whose numerator is the remaining useful life and whose denominator is the SYD. Thus in our example the calculation would: First year depreciation Second year depreciation Third year depreciation Fourth year depreciation Fifth year depreciation = = = = = 5/15 4/15 3/15 2/15 1/15 Depreciation Depreciation Depreciation Depreciation Depreciation cost cost cost cost cost

The formula for depreciation for this method is: Depreciation = Depreciation cost (Remaining useful life/SYD)

Example:
ABC Ltd. purchased a truck for $65,000 on 1st January 1991. The expected life was 5 years and salvage value $5,000. Calculate the annual depreciation expense by applying sum-of-the-years' digits (SYD) method.

Solution:
Amount to be written of = $65,000 - 5,000 = 60,000 SYD = 1 + 2 + 3 + 4 + 5 = 15 The annual depreciation is: First year depreciation Second year depreciation Third year depreciation Fourth year depreciation Fifth year depreciation Total = = = = = 5/15 4/15 3/15 2/15 1/15 60,000 60,000 60,000 60,000 60,000 = = = = = 20,000 16,000 12,000 8,000 4,000 60,000

When the asset is acquired during the year, the depreciation expense may be determined by dividing the fractional multipliers between the current and succeeding year. Using the data in the above example suppose the truck is purchased on 30thJune 1991, the depreciation is computed as follows:
End of the year 1. 2. 3. 4. 5. 6. Depreciable cost 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 Years' fraction 5/15 (1/2) Years' depreciation 10,000 10,000 8,000 8,000 6,000 6,000 4,000 4,000 2,000 2,000 Accumulated depreciation 1,000 28,000 42,000 52,000 58,000 60,000 Cost 65,000 65,000 65,000 65,000 65,000 65,000 Book value 55,000 37,000 23,000 13,000 7,000 5,000

] ] ]

5/15 (1/2) 4/15 (1/2) 4/15 3/15 3/15 2/15 2/15 1/15 (1/2) (1/2) (1/2) (1/2) (1/2) (1/2)

1/15 (1/2)

Scope of the Sum of Years' Digits Method (SYD):

As an accelerated depreciation method, the SYD approach is most appropriate for those situations in which the asset is judged to render greater utility during its earlier life and less in its later life.

Double Declining Balance Method of Depreciation:

Learning Objectives: 1. Define and explain the double declining balance method of depreciation. Double declining balance method is another type of accelerated depreciation method followed generally in USA. The depreciation expense is computed by multiplying the asset cost less accumulated depreciation by twice the straight line rate expressed in percentage. No provision is made for salvage value of the asset.

Double declining balance rate is found by using the following formula: Double Declining Balance Rate = (100%/Years of Useful Life) 2

Example:
A printing machine is purchased for $20,000 on January 1991. The scrap value is estimated at $2,000 at the end of 5 years useful life of the asset. Required: Calculate the annual depreciation charge by applying double declining balance method

Solution:
Depreciation rate (100%/5) 2 = 40% The following table shows the depreciation for the five year period:
End of Year 1 2 3 4 5 Asset Cost 20,000 20,000 20,000 20,000 20,000 Rate depreciation 40% 40% 40% 40% 40% Amount depreciation 8,000 4,800 2,880 1,728 1,037 accumulated depreciation 8,000 12,800 15,680 17,408 18,445 Book Value 12,000 7,200 4,320 2,592 1,555

In applying this method the entire original cost can never be depreciated. There is bound to be some balance though only a small one. In this example, a salvage value of $1,555 is automatically provided for. However, an asset should not be depreciated below it salvage value of $2,000. Therefore the depreciation expenses at the end of fifty year should be $592 and not $1,037.

Depletion Method of Depreciation:

Learning Objectives:

1. What is depletion method of depreciation? Explain with example.

Depletion method of depreciation is especially suited to mines, quarries, sand pits, etc. According to it the cost of the asset is divided by the total workable deposits. In this way, rate of depreciation per unit of output is ascertained. Depreciation in any particular year is charged on the basis of the output during that year.

Example:
A mine was acquired at a cost of $20,00,000 the quantity of minerals expected to be mined is 5,00,000 tons, the rate of depreciation per unit will be $4 i.e., (20,00,000 / 5,00,000). If during the year 25,000 tons minerals is extracted, the amount of depreciation will be 25,000 4 = $1,00,000.

Basis of Use System of Depreciation of Depreciation:

Learning Objectives: 1. Define and explain the basis of use system of depreciation. One of the chief factors causing depreciation is use. For example in the case of plant and machinery, it is the total number of hours for which the machines work is the main factor and not their life. Therefore, depreciation should be charged on the basis of use. In order to calculate, the total number of hours for which the machine is estimated to work is ascertained. The net cost of the asset is divided by the number of hours estimated and the result would give the amount of depreciation per hour. Each year depreciation would be written off at this rate on the number of hours worked during the year.

Example:
A machine is bought for $40,000 and its life is estimated at 20,000 hours. The hourly rate of depreciation will be $2. If in a year machine is used for 1,000 hours, depreciation will be $2,000 (1,000 2).

Depreciation of Various Assets:

Learning Objectives: 1. How should the depreciation on various assets be calculated?. We discuss below the problem of depreciating some given assets.

Freehold Land and Building:

It means that land and building which has been purchased out right and not on lease. In the case of building it will be seen that in its early life, few repairs will be needed. These repairs will keep the building in proper order. But after sometime the building will begin to decay and even the repairs will not succeed in keeping it in proper working order. Efficient repairs, no doubt, add to the life of the building, but they cannot make it everlasting. After some considerable time the building will practically fall in spite of all the repairs. Hence it is absolutely necessary to charge depreciation on such building, so that by the time it falls down, its book value also disappears from the books of accounts. As this asset possesses a long life, the method of depreciation employed should be such as it provides a fund for its reconstruction on its dilapidation. Thus either of the straight line method or reducing installment method may be adopted to depreciate this asset. One of the peculiarly of the land is that it does not generally depreciate. Its value may and does fluctuate from time to time, but such fluctuations do not influence depreciation in any way. Consequently older accountants were of the opinion that land should be left at the cost price in the books. According to modern opinion the idea of the depreciation with regard to land cannot be ruled out entirely. Agricultural land may loss its fertility. Brick land may depreciate. as such, in some cases at least land must be depreciated.

Leasehold Land and Building:

By leasehold is meant the land that is taken on lease for a certain number of years. The most general duration is 99 years, but may of course be less or much more. If the lease under which the property is acquired is short, the fixed installment method or straight line method of depreciation can be applied conveniently. If on the other hand, it be a long lease, the annuity method of depreciation would be more suitable. The value of the leasehold property should be written off during the term of the lease and the rate of depreciation should be fixed accordingly.

Plant and Machinery:

This term includes machinery of different kinds e.g., engines, boilers, fixed plant, running machinery, etc. As the working life of each one of them is different, the rate of depreciation should also be different. Though fixed installment method or straight line method can be suitably applied to depreciating plant and machinery but owing to the difficulty of calculating depreciation on additions made during the year, the diminishing balance method is generally employed to depreciate this asset.

Loose Tools:
As this asset is liable to breakage and pilferage, it should be annually valued. The difference between the present value and the value as per last balance sheet should be treated as depreciation.

Furniture and Fixture:

The diminishing balance method is usually employed to depreciate this asset. The rate of depreciation should be high enough to reduce it to its residual value at the end of its working life.

Patents and Copyrights:

There is a maximum legal life of such assets but the commercial life (during which such assets can be effectively exploited) may even be shorter. The assets should be depreciated by the straight line method so that it is written off within the legal or commercial life whichever is shorter.

Mines, Oil Well, Quarries, Etc:

The depreciation should be estimated by the depletion method.

Goodwill:
Goodwill has been defined as the benefit or advantage arising from regular public patronage on account of facilities offered. The name under which the business is carried on acquires a reputation and consequently a saleable value. It can be sold only when entire business is sold off. It is an intangible asset. Though goodwill is a fixed asset it does not depreciate on account of wear and tear like plant and machinery etc. As goodwill is not consumed in the process of earning income, it is not necessary to depreciate it. But as no business, howsoever well established, can have perpetual life, it is advisable to create a reserve from the profit and loss account in prosperous years because when profits fall and goodwill depreciates it may be difficult to write it off.

Depreciation Accounting - General Questions and Answers:

Learning Objectives: 1. Answers of some of the general questions about depreciation accounting.

Theoretical:
1. What is depreciation and how is it brought about? 2. Name the different methods of providing for depreciation, and discuss any one of them in detail? 3. Explain the difference between (i) depreciation and fluctuation (ii) depreciation and obsolescence. How should obsolescence be provided for. 4. What are the objects of making provision for depreciation of the fixed assets of a business. 5. Why should depreciation on fixed assets be brought into account. Discuss in detail the several methods of providing for depreciation. 6. What is depreciation? Does it depend on the market value of the asset? Why is it necessary to provide for depreciation of assets while preparing the balance sheet. 7. Explain briefly the nature and use of the "revaluation process" of depreciation. 8. Which is the best method of providing for depreciation of the following assets: Loose tools, machinery, live stock, lease, motor vehicles.

Answers: To find the answers of all the questions above, please read our accounting for depreciation chapter in detail. Click here to start now.

Objectives:
A. State whether each of the following statements are true or false:

1. The objective of charging profit and loss account with the amount of depreciation is to spread the cost 2. 3.
of an asset over its useful life for the purpose of income determination. The amount of depreciation is credited to depreciation fund account in case of annuity method. The charge for use of the asset remains uniform each year in case of straight line method. Depreciation is charged on the book value of the asset each year in case of diminishing balance method. Depletion method is suitable for charging depreciation in case of stock or loose tools. Net charge to the profit and loss account is the same under both annuity method and depreciation fund method. The amount of depreciation is credited to the depreciation fund account in the depreciation fund method. The asset appears always at original cost in case depreciation is credited to provision for depreciation account. In case of insurance policy method, the depreciation is credited to the asset account.

4. 5. 6. 7. 8. 9.

Answers: 1 True 2 False 3 False 4 True 5 False 6 True 7 True 8 True 9 False

B. Indicate the alternative which you consider to be correct.

1. Depreciation is a process of:

i. Valuation. ii. Allocation. iii. Both valuation and allocation. iv. Non of these.

2. The main objective of providing depreciation is:

i. To allocate true profit. ii. To show the true financial position in the balance sheet. iii. To reduce tax burden. iv. To provide funds for replacement of fixed assets.

3. Depreciation arises because of:

i. Fall in the market value of an asset. ii. Physical wear and tear.

iii. Fall in the market value of money.

4. Under the straight line method of charging depreciation, it:

i. Increases every year. ii. Decreases every year. iii. Is constant every year.

5. Under the diminishing balance method, the depreciation is calculated on:

i. Original cost. ii. Written down value. iii. The scrap value

6. A diminishing balance method of providing depreciation is one according to which:

i. The amount of depreciation is reduced year to year. ii. The rate percent of depreciation declines from year to year. iii. The rate percent as well as the amount reduces every year.

7. Depreciation on diminishing balance method of $2,000 at the rate of 10% p.a after three years will be:
i. $1,400 ii. $1,458 iii. $542 iv. Non of the above.

8. The amount of depreciation charged on a machinery will be debited to:

i. Machinery a/c. ii. Depreciation account. iii. Cash account.

9. Loss on the sale of machinery should be written off against:

i. Share premium account. ii. Sales account iii. Depreciation fund account Answers: 1 ii 2 i 3 ii 4 iii 5 ii 6 i 7 iv 8 ii 9 iii

C. Fill in the blanks 1. The total amount of depreciation to be written off over the life of an asset is equal to the cost of the asset less its ________. 2. Obsolescence and inadequacy are called the ________ factors causing depreciation.

3. Over or under provision of ________ is taken to profit and loss account as profit or loss at the time of
termination or sale of assets. 4. The useful life of depreciable asset for an enterprise may be ________ than its physical life. This is usually because of such factors as _________ and ________. 5. In the case of wasting assets the amount of charge determined on the basis of exhaustion of the asset is known as ________. Answers: 1 scrape value 2 economic 4 shorter, obsolescence, depreciation inadequacy 3 5 depletion